William Bernstein Interview #2: No Individual Stocks, Improved Safe Withdrawal Rate Outlook

Posted on July 30, 2023 // Leave a Comment

Dr. William Bernstein is continuing his press tour for the second edition of his classic investing book The Four Pillars of Investing, and I found myself listening/reading to another podcast from The Meb Faber Show: Bill Bernstein on Financial History, Star Managers & The 4 Pillars of Investing.

There was some overlap between his discussion points here and the Morningstar podcast, but it was definitely worth the time spent to get a few more interesting discoveries.

He owns zero individuals stocks. I’m pretty impressed by the discipline level of this. No vestigial stock shares from his youth, no sentimental holdings, not even a humblebrag holding. (“Well, I do have a few shares of Apple that I picked up during the IPO in 1980…”)

Meb Faber: Does Dr. Bernstein have a play account? Do you allow yourself to have some investments you’ll trade around a little bit or are you too strict for that?

Dr. Bernstein: No. For two reasons, number one is, I learned my lesson early on just like you did. And, number two, I also am a co-principal in an IRA firm, and I just don’t want to be dealing with trading individual stocks.

He thinks that safe withdrawal rates are improving.

I am reasonably optimistic, as optimistic as I’ve actually been in 15 or 20 years about securities returns in about people’s ability to spend. What we told people until relatively recently was if you’re a typical 65-year-old retiree, a 2% burn rate is bulletproof, 3% is probably safe, 4%, you’re probably taking some risk, and at 5% burn rate, you’re taking a real risk. And I think that given the increase in real bond rates and the general decrease in valuations almost everywhere in the world except in the U.S. and especially with U.S. large cap stocks, I think that expected returns have increased to the point that you can increase those burn rates by about a percent. And that may not sound like very much, but going from 2% to 3% gives you 50% more spending power each and every year. So, I’m reasonably optimistic about future security returns, both for people who are going to be putting money away, and people who are going to be spending as well, assuming they didn’t get too badly clobbered in 2022.

Adding in that additional percentage point would change the quote to “if you’re a typical 65-year-old retiree, a 3% burn rate is bulletproof, 4% is probably safe, 5%, you’re probably taking some risk, and at 6% burn rate, you’re taking a real risk.” That is a big change, as he says.

Filed Under: Investing //

Fundrise vs. Vanguard Real Estate ETF REIT Review 2023 (Final Update and Cashout!)

Posted on July 26, 2023 // 40 Comments

Final update July 2023, with full cashout. It has now been nearly 6 years for my experiment comparing a Fundrise Real Estate portfolio and the Vanguard Real Estate ETF. In Fundrise, we have a start-up with “crowdfunding” beginnings that offers users a share of a concentrated basket of properties actively chosen from the private market. In Vanguard, we have a one of the largest real estate ETFs in the world – users own a tiny passive slice of ~165 public-traded REITs. I invested $1,000 into both in October 2017 and cashed out in July 2023, for a holding period of 5 years and 9 months.

fundrise_logo

Fundrise Starter Portfolio background. When I bought in, the Fundrise Starter Portfolio was a simple 50/50 mix of two eREITs: the Fundrise Income eREIT and the Fundrise Growth eREIT*. Since these are finite baskets of entire properties, over time they will close one fund and start another similar basket. What new investors are buying today will be different apartment complexes and office buildings than what I bought in 2017. Here were my holding as of the end of June 2023:

Each private eREIT works within recent crowdfunding legislation that allows all investors to own a basket of individual real estate properties (not just accredited investors with high net worth). The minimum deposit is now just $10. You must buy shares directly from Fundrise, and there are only limited quarterly liquidity windows as this is meant to be a long-term investment. There are also additional options available with higher investments:

Vanguard REIT ETF background. The Vanguard REIT ETF (VNQ) is the ETF share class of a $60+ billion index fund that invests in publicly-traded real estate investment trusts (REITs). You can purchase it via any brokerage account. You have the liquidity of being to sell on any day the stock market is open. A single share currently costs about $100, but many brokers offer fractional dollar-based trades if you want. All shareholders are holding the same ratio of (tens of?) thousands of office buildings, hotels, storage centers, nursing homes, shopping centers, apartment complexes, timber REITs, mortgage REITs, and so on. Here is a recent breakdown:

Expenses. The Fundrise Starter Portfolio has an 0.85% annual asset management fee and a 0.15% annual investment advisory fee (1% “all-in” total). The Vanguard REIT ETF has an expense ratio of 0.12% on top, but each public REIT also has their own internal costs like employee salaries to manage their properties. In each case, investors are paying for real estate management, office space and salaries for those employees, etc. REITs may also use debt to increase their real estate exposure (leverage). Is the technology offered by Fundrise a more efficient way to invest in real estate?

Final performance numbers. Based on an initial $1,000 investment in October 2017 and immediately reinvestment of all dividends, here are the monthly balances of my Fundrise portfolio vs. the Vanguard REIT ETF.

Again, there are quarterly redemption windows, and I initiated my request for a full withdrawal May 26, 2023 in preparation for the end of the second quarter on June 30th. On July 4th, I was notified that my request was approved, and I received the funds into my bank account on July 7th.

While the balances have much closer at times, the final balance was $1,931 (12.2% annualized return) for Fundrise, compared to only $1,272 (4.3% annualized return) for the Vanguard REIT ETF. The final endpoint is probably the widest margin during the entire experiment.

Commentary. One issue with this comparison is that this chart uses two different types of NAVs (net asset values). Vanguard updates the NAV daily based on the combined agreement of millions of investors. Every trading day, there is a price where you can liquidate your VNQ shares. Meanwhile, Fundrise NAVs are only estimates as there is no daily market value available since they hold entire apartment complexes, office buildings, and so on (similar to your house, but with even fewer comps). Your liquidity from Fundrise is limited to quarterly windows that are not guaranteed. That is why I wanted to finish this experiment will a full cash-out, so we can at least somewhat test if the NAVs are realistic. I was honestly a bit skeptical that the Fundrise NAVs could keep going up while the VNQ NAVs were struggling, but they did cash me out at the NAVs they posted. I have to give them credit for that. In the end, perhaps Fundrise is closer to owning a basket of pieces of real apartment complexes and buildings, in that the rising interest rates really didn’t hurt residential housing prices so far either.

The potential drawbacks still remain. In a more stressful bear market, the liquidity is not guaranteed and neither is the NAV if you were forced to liquidate the entire thing as opposed to trading existing shares to new investors. I made my withdrawal request before the sudden PeerStreet bankruptcy filing, but Fundrise is also a young company without a long history of profitability. (Fundrise does benefit from earning ongoing management fees on the assets under management, while PeerStreet earned a cut of the loan proceeds. Without a steady stream of new loans, PeerStreet quickly stopped making as much money.)

Bottom line. I have finally concluded a nearly 6-year experiment (5 years was the initial goal) where I compared investing $1,000 each into real estate via Fundrise direct active investment and the passive REIT index ETF from Vanguard. Based on actual cash-out numbers, Fundrise final balance was $1,931 (12.2% annualized return), while the Vanguard REIT ETF final balance was $1,272 (4.3% annualized return).

You can learn more about all Fundrise Real Estate options here. Anyone can invest with Fundrise; you don’t need to be an accredited investor.

Filed Under: Investing, Real Estate //

Why Vanguard Money Market Funds Are Still The Best

Posted on July 20, 2023 // 20 Comments

The term “Vanguard effect” was coined due to the observation that after Vanguard enters an asset class with its low expense ratios, competitors are usually forced to follow and lower their expense ratios as well. However, one area where this effect not being seen is money market funds.

Part of the reason is that the megabanks are still paying basically zero, so the 4% from an average money market fund still looks great in comparison. Here’s a chart showing the nearly half-trillion dollars of bank deposits moving over to money market funds over the past year (source).

Let’s compare S&P 500 index funds. The Fidelity 500 Index Fund (FXAIX) has a tiny expense ratio of 0.015%. The Vanguard 500 Index Fund (VFIAX) has an expense ratio of 0.04%. If you assume that Vanguard is operating “at cost”, Fidelity is actually choosing to lose some money to be a little cheaper than Vanguard. If it matched Vanguard’s expense ratio, at the current size it would earn an extra $10 million. There is such a thing as “indexing skill”, but going forward you could honestly see Fidelity 500 outperforming Vanguard 500 by a slim margin.

Now let’s compare money market funds. The Fidelity Government Money Market Fund (SPAXX) has $270 billion in total assets and an expense ratio of 0.42%. This means this fund generates roughly $1+ Billion of revenue for Fidelity every year.

Meanwhile, the Vanguard Federal Money Market Fund (VMFXX) is nearly the same size at $250 billion of total assets, but only a 0.11% expense ratio. That works out to $275 million of revenue. If you assume again that Vanguard is operating “at cost”, that means Fidelity is earning an extra $800 million a year by not lowering its expense ratio to the same level.

Money market mutual funds are regulated so tightly now, especially those with “government” or “treasury” in their name, that they can pretty much only invest in the same things and thus earn the same yield. The only way that the customer earns more interest is if the mutual fund provider charges less in fees. It’s pretty much a zero-sum game.

Fidelity Government Money Market Fund (SPAXX) pays you 4.73% and pays itself 0.42%. The total yield is 5.15%.

Vanguard Federal Money Market Fund (VMFXX) pays you 5.06% and pays itself 0.11%. The total yield is 5.17%.

The pie is required to be nearly the same for both funds (same ingredients in nearly the same proportions), but with Vanguard the customer gets a much bigger slice. There is nearly zero chance that over time, Fidelity will give you a higher return on Vanguard here.

Now, there are institutional class funds with $50 million minimums that also have low expense ratios, but these are funds that Vanguard uses as their default cash sweep! I could have $100 with Vanguard and get access. The moment any capital gains, dividends, or interest payments are distributed, they are earning a competitive interest rate without any work on my part. You know what Merrill Edge pays me on my default cash sweep? 0.01%.

Vanguard published an interview with their head of taxable money market funds that covers a lot of interesting background details about money market funds: Vanguard’s Nafis Smith on the enduring advantage of low-fee money market funds. (Well, interesting to me.) Here are my highlights:

There are technically four types of money market funds (Treasury, government, municipal, and prime) and each are regulated very tightly by SEC Rule 2a-7, and even more so after the 2008 Financial Crisis.

The primary mandate of any money market fund is to seek both stability and provide current income. In a rising interest rate environment, any of these four types of money market funds—U.S. Treasury, government, municipal, and prime funds—should meet that decree. They all hold high-quality assets, are very liquid, and are subject to the same SEC regulation, Rule 2a-7, which is very prescriptive in terms of how much duration risk a fund can take on and how much liquidity must be maintained.

For example, all “government money market funds” must invest at least 99.5% of their assets in cash, U.S. Government Securities, and/or repurchase agreements that are collateralized solely by U.S, Government Securities or cash.

In terms of duration and liquidity, all taxable funds must hold at least 10% of their assets in investments that can be converted into cash within one day. At least 30% of assets must be able to be converted into cash within five business days. Finally, no more than 5% of assets can take more than a week to convert into cash.

Money market funds have only “broken the buck” (paid out less than the $1 NAV) twice, the worst case for 96 cents on the dollar.

Since their introduction in 1971, money market funds have broken the buck just two times. The first was in 1994, when a fund was liquidated at 96 cents per share because of large losses in derivatives.3 The second was during the financial crisis of 2008, because of assets held with the then recently bankrupt Lehman Brothers.4

In response to the 2008 event, the Securities and Exchange Commission amended Rule 2a-7,5 which increased the resilience of money market portfolios and made them much safer than they used to be. Since then, we’ve seen several additional rounds of reform. In short, breaking the buck was a rare event before, but since the regulations have changed, it’s even less likely to occur.

More detail on repurchase agreements and why they are more popular right now (to reduce interest rate volatility).

Fed repurchase agreements are very common in the money market space. It’s an overnight lending arrangement between us, in this instance, and the Federal Reserve, which is one of the world’s highest-quality organizations in terms of credit risk. We’re lending cash and receiving U.S. Treasuries, which are extremely high-quality securities held on the Federal Reserve’s balance sheet. The Fed buys back the U.S. Treasuries the next day at a higher price based on Fed target rates, which provides income to money markets.

In a rising interest rate environment like the one we’re experiencing, any repurchase agreements are very good at dampening market volatility because they allow us to increase stability by reducing interest rate risk. Repurchase agreements also allow us to pass along the higher interest rate to investors much more quickly.

Vanguard’s low expense ratios allows their customers to get both the highest yield AND the safest assets with a very low minimum balance requirement. This makes them the best money market funds.

Our greatest advantage is our low expense ratio, which allows us to do things differently than some of our competitors. We don’t have to take on unnecessary risk to reach for yield, and we can manage our portfolios with much shorter durations, maintain higher credit standards, and enforce stricter underwriting standards for our repurchase agreements while still offering a competitive return.

Filed Under: Banking, Investing //

Bill Bernstein Interview: New Edition of The Four Pillars of Investing Book

Posted on July 18, 2023 // Leave a Comment

“The Long View” by Mornginstar is an excellent podcast for DIY investors with a long-term perspective. Their recent episode Bill Bernstein: Revisiting ‘The Four Pillars of Investing’ had on Dr. Bernstein to help promote his newly-updated The Four Pillars of Investing, Second Edition*. I haven’t read the new edition yet, but the podcast alone was full of useful evidence and unique nuggets.

(* I found it amusing that Amazon was advertising a book titled “Learn Proven Day Trading Strategies” on the same page. What an oxymoron! I seriously worry about new investors finding the good stuff amongst all this noise.)

I recommend listening or reading the handy podcast transcript, but here are my top takeaways and highlights.

Don’t interrupt compounding. Have enough safe assets to make it through the next crisis, which will inevitably arrive sooner or later.

[…] yes, compounding is magic, but you have to observe Charlie Munger’s prime directive of compounding, which is never to interrupt it. So, you have to design your portfolio not with the normal 98% of the world and 90% of the time in mind. You have to design your portfolio with the worst 2% of the time in mind so that you don’t interrupt compounding, which basically translated into plain English means that you probably should have more safe assets than you think you should have. In other words, a suboptimal portfolio that you can execute is better than a stock-heavy optimal one that you cannot execute.

Why you may prefer to own Treasury bonds over Corporate bonds, even if the latter has a slightly higher average return.

[…] it’s not just that you have the risk of bad returns, it’s bad returns in bad times. And that’s the problem with corporate bonds, is when corporate bonds do poorly, they do poorly at the worst possible time.

[… the] 0.8% or 0.6% returns premium you get over Treasuries from high-grade corporate bonds just isn’t worth it.

Have realistic expectations if you tilt to factors like size, value, quality, and so forth.

I think that in finance, even the best bets you make are at best 60/40, most of the time they’re closer to 51/49. So, you just have to resign yourself to the fact that you’re going to be wrong a large part of the time in exchange for being right most of the time. And even then, the margin isn’t going to be that much.

How to protect your portfolio against inflation.

Well, for starters, you keep your bond duration short so that when rates rise, you can roll them over at the higher rate. And stocks, although stocks don’t do well initially with inflation, what you see is that over the very, very, long term, they do.

The hazards of backtesting. Whatever has performed well mostly recently will overwhelm the results.

What happened back in the 1970s and ‘80s and ‘90s is people fell in love with mean-variance optimization, the Markowitz algorithm. It looked like all you had to do was collect asset-class returns and standard deviations and the correlation grid, which is the inputs to the Markowitz algorithm. And you could predict the future-efficient frontier, that is the allocation that gave you the most amount of return for a given degree of risk or for a given degree of return that stopped you with the lowest degree of volatility. And it turns out that the inputs to that produce enormous changes in the outputs and that the algorithm, if you’re going to use historical returns, then favors the asset classes with the highest returns.

Why not 100% stocks for young folks?

There is a wonderful quote from Fred Schwed’s marvelous book, Where Are the Customers’ Yachts?

“There are certain things that cannot be adequately explained to a virgin, either by words or pictures, nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own. If you’re a young investor, you’re an investment virgin, you’ve never lost a real chunk of money, and you have no idea how you’re actually going to respond to stocks falling by 30% or 50%.”

Asset allocation for early retirees:

Someone who is a FIRE person—financial independence, retire early—and wants to retire at age 40, better have a fairly aggressive allocation with a very low burn rate.

Not a fan of lifetime income via annuities. First, they are greatly exposed to inflation risk. Second, they are exposed to credit risk (insurance company failure). He is skeptical about the state guaranty system.

These are all commercial products and people are very fond of pointing out, yes, these products have state guarantees, but of course, they’re funded by the insurance industry. There is nothing magic about a state guarantee. Most states have fairly low caps on the amount that is protected. And then, finally, even those guarantees can fail. And if you don’t think that that can happen, you should go Google “Executive Life Insurance.”

Filed Under: Investing //

Money Market Mutual Funds, Repurchase Agreements, and State/Local Tax Exemptions

Posted on July 13, 2023 // 3 Comments

If you live in a state that taxes interest income, you may know that can significantly alter the net after-tax yield on your investments. This is because direct U.S. government obligations like Treasury bills and bonds are generally exempt from taxation in most states. For example, if a Treasury bill is yielding 5% but is exempt from a 8% state income tax, that would make it the equivalent after-tax yield of a bank CD at 5.65% APY (assuming 22% federal tax rate). That’s a pretty big difference! See Treasury Bond vs. Bank CD Rates: Adjusting For State and Local Income Taxes for details.

Money market mutual funds (available in most brokerage accounts) usually hold part of their portfolio in securities that count as US government obligations (USGO). (See Vanguard Federal Money Market Fund: How to Claim Your State Income Tax Exemption.)

For the 2022 tax year, Vanguard Federal Money Market Fund (VMFXX) had about 38% in USGOs, but the Vanguard Treasury Money Market Fund (VUSXX) had 100% in USGOs (source). As long as the yields were pretty close, your after-tax yield would be much higher with the Treasury Money Market fund if you were in a high state/local tax bracket. (VMFXX is the default sweep though, so you’d have to manually purchase VUSXX.)

However, these USGO percentages can change from year to year, and it is happening in 2023. A quick rewind – here is a list of what is and is not exempt from state and local taxes.

*Investments in U.S. government obligations may include the following: Federal Farm Credit Banks, Federal Home Loan Banks, the Student Loan Marketing Association, the Tennessee Valley Authority, the U.S. Treasury Department (bonds, notes, bills, certificates, and savings bonds), and certain other U.S. government obligations. GNMA, FNMA, Freddie Mac, repurchase agreements, and certain other securities are generally subject to state and local taxes.

In particular, even though the Vanguard Treasury Money Market Fund has “Treasury” in its name, it doesn’t only hold Treasury Bonds. It can also hold something called repurchase agreements (“repos”). These are often sold on a very short-term basis (overnight or less than 48 hours). While a repo is considered a very, very safe loan backed by government securities, it is not itself a government security, which means the income it creates is taxable at the state and income level.

As of July 2023, here is the percentage of repurchase agreements held by these two example money market funds: 58% for VMFXX and 34% for VUSXX. This would suggest that the USGO number for VUSXX will be significantly less than 100% for 2023, although VUSXX still holds less repos than VMFXX.

For an in-depth comparison, “retiringwhen” of the Bogleheads forum has created a detailed Google Spreadsheet that tracks and calculates the after-tax yields for several different money market funds from Vanguard and Fidelity. I would point out that the low expense ratio of Vanguard funds makes their money market funds consistently better than Fidelity money market funds across the board.

I also hold some Treasury bonds directly and while laddering isn’t that much hassle, recently I have been considering simplifying to VMFXX and VUSXX as the go-to place for my liquid cash savings account. For now, the tax-equivalent yield is higher than nearly all other savings accounts due to my high state-tax situation. I am also looking at ETFs that hold mostly T-bills like SGOV and BIL.

Bottom line. If you want to be precise, the full-geek DIY investor with state/local income taxes has to take into account the percentage of repos in their money market fund portfolios in order to calculate the true tax-equivalent yield to compare against other cash alternatives.

[Top image credit – Wikipedia]

Filed Under: Banking, Investing, Taxes //

Best Interest Rates on Cash – July 2023

Posted on July 9, 2023 // 5 Comments

Here’s my monthly roundup of the best interest rates on cash as of July 2023, roughly sorted from shortest to longest maturities. There are often lesser-known opportunities available to individual investors. Check out my Ultimate Rate-Chaser Calculator to see how much extra interest you could earn from switching. Rates listed are available to everyone nationwide. Rates checked as of 7/8/2023.

TL;DR: 5% APY available on liquid savings. 5% APY available on multiple short-term CDs. Compare against Treasury bills and bonds at every maturity.

Fintech accounts
Available only to individual investors, fintech companies often pay higher-than-market rates in order to achieve fast short-term growth (often using venture capital). “Fintech” is usually a software layer on top of a partner bank’s FDIC insurance.

  • 5.15% APY ($1 minimum). SaveBetter lets you switch between different FDIC-insured banks and NCUA-insured credit unions easily without opening a new account every time, and their liquid savings rates currently top out at 5.15% APY from multiple banks. See my SaveBetter review for details. SaveBetter does not charge a fee to switch between banks.
  • 5.20% APY (before fees). MaxMyInterest is another service that allows you to access and switch between different FDIC-insured banks. You can view their current banks and APYs here. As of 7/8/23, the highest rate is from Customers Bank at 5.20% APY. However, note that they charge a membership fee of 0.04% per quarter, or 0.16% per year (subject to $20 minimum per quarter, or $80 per year). That means if you have a $10,000 balance, then $80 a year = 0.80% per year. This service is meant for those with larger balances. You are allowed to cancel the service and keep the bank accounts, but then you may lose their specially-negotiated rates and cannot switch between banks anymore.

High-yield savings accounts
Since the huge megabanks STILL pay essentially no interest, everyone should have a separate, no-fee online savings account to piggy-back onto your existing checking account. The interest rates on savings accounts can drop at any time, so I list the top rates as well as competitive rates from banks with a history of competitive rates. Some banks will bait you with a temporary top rate and then lower the rates in the hopes that you are too lazy to leave.

  • The leapfrogging to be the temporary “top” rate continues. CFG Bank at 5.17% APY. CIT Platinum Savings at 4.95% APY with $5,000+ balance.
  • SoFi Bank is now up to 4.30% APY + up to $275 new account bonus with direct deposit. You must maintain a direct deposit of any amount each month for the higher APY. SoFi has their own bank charter now so no longer a fintech by my definition. See details at $25 + $250 SoFi Money new account and deposit bonus.
  • There are several other established high-yield savings accounts at 4.00%+ APY that aren’t the absolute top rate, but historically do keep it relatively competitive for those that don’t want to keep switching banks.

Short-term guaranteed rates (1 year and under)
A common question is what to do with a big pile of cash that you’re waiting to deploy shortly (plan to buy a house soon, just sold your house, just sold your business, legal settlement, inheritance). My usual advice is to keep things simple and take your time. If not a savings account, then put it in a flexible short-term CD under the FDIC limits until you have a plan.

  • No Penalty CDs offer a fixed interest rate that can never go down, but you can still take out your money (once) without any fees if you want to use it elsewhere. CIT Bank has a 11-month No Penalty CD at 4.90% APY with a $1,000 minimum deposit. Ally Bank has a 11-month No Penalty CD at 4.25% APY for all balance tiers. Marcus has a 13-month No Penalty CD at 4.35% APY with a $500 minimum deposit. You may wish to open multiple CDs in smaller increments for more flexibility.
  • Blue FCU via SaveBetter has a 9-month No Penalty CD at 5.00% APY. Minimum opening deposit is $1. No early withdrawal penalty. Withdrawals may be made 30 days after opening.
  • First Internet Bank has a 12-month certificate at 5.48% APY. $1,000 minimum. Early withdrawal penalty is 180 days of interest.

Money market mutual funds + Ultra-short bond ETFs*
Many brokerage firms that pay out very little interest on their default cash sweep funds (and keep the difference for themselves). * Money market mutual funds are regulated, but ultimately not FDIC-insured, so I would still stick with highly reputable firms. I am including a few ultra-short bond ETFs as they may be your best cash alternative in a brokerage account, but they may experience losses.

  • Vanguard Federal Money Market Fund is the default sweep option for Vanguard brokerage accounts, which has an SEC yield of 5.04%. Odds are this is much higher than your own broker’s default cash sweep interest rate.
  • The PIMCO Enhanced Short Maturity Active Bond ETF (MINT) has a 5.43% SEC yield and the iShares Short Maturity Bond ETF (NEAR) has a 5.47% SEC yield while holding a portfolio of investment-grade bonds with an average duration of ~6 months.

Treasury Bills and Ultra-short Treasury ETFs
Another option is to buy individual Treasury bills which come in a variety of maturities from 4-weeks to 52-weeks and are fully backed by the US government. You can also invest in ETFs that hold a rotating basket of short-term Treasury Bills for you, while charging a small management fee for doing so. T-bill interest is exempt from state and local income taxes.

  • You can build your own T-Bill ladder at TreasuryDirect.gov or via a brokerage account with a bond desk like Vanguard and Fidelity. Here are the current Treasury Bill rates. As of 7/7/23, a new 4-week T-Bill had the equivalent of 5.27% annualized interest and a 52-week T-Bill had the equivalent of 5.43% annualized interest.
  • The iShares 0-3 Month Treasury Bond ETF (SGOV) has a 5.12% SEC yield and effective duration of 0.10 years. SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL) has a 4.98% SEC yield and effective duration of 0.08 years.

US Savings Bonds
Series I Savings Bonds offer rates that are linked to inflation and backed by the US government. You must hold them for at least a year. If you redeem them within 5 years there is a penalty of the last 3 months of interest. The annual purchase limit for electronic I bonds is $10,000 per Social Security Number, available online at TreasuryDirect.gov. You can also buy an additional $5,000 in paper I bonds using your tax refund with IRS Form 8888.

  • “I Bonds” bought between May 2023 and October 2023 will earn a 4.30% rate for the first six months. The rate of the subsequent 6-month period will be based on inflation again. More on Savings Bonds here.
  • In mid-October 2023, the CPI will be announced and you will have a short period where you will have a very close estimate of the rate for the next 12 months. I will have another post up at that time.
  • See below about EE Bonds as a potential long-term bond alternative.

Rewards checking accounts
These unique checking accounts pay above-average interest rates, but with unique risks. You have to jump through certain hoops which usually involve 10+ debit card purchases each cycle, a certain number of ACH/direct deposits, and/or a certain number of logins per month. If you make a mistake (or they judge that you did) you risk earning zero interest for that month. Some folks don’t mind the extra work and attention required, while others would rather not bother. Rates can also drop suddenly, leaving a “bait-and-switch” feeling.

  • Genisys Credit Union pays 5.25% APY on up to $7,500 if you make 10 debit card purchases of $5+ each, and opt into receive only online statements. Anyone can join this credit union via $5 membership fee to join partner organization.
  • Pelican State Credit Union pays 5.50% APY on up to $10,000 if you make 15 debit card purchases, opt into online statements, and make at least 1 direct deposit, online bill payment, or automatic payment (ACH) per statement cycle. Anyone can join this credit union via partner organization membership.
  • The Bank of Denver pays 5.00% APY on up to $25,000 if you make 12 debit card purchases of $5+ each, receive only online statements, and make at least 1 ACH credit or debit transaction per statement cycle. Thanks to reader Bill for the updated info.
  • All America/Redneck Bank pays 5.30% APY on up to $15,000 if you make 10 debit card purchases each monthly cycle with online statements.
  • Presidential Bank pays 4.62% APY on balances between $500 and up to $25,000 (3.625% APY above that) if you maintain a $500+ direct deposit and at least 7 electronic withdrawals per month (ATM, POS, ACH and Billpay counts).
  • Find a locally-restricted rewards checking account at DepositAccounts.

Certificates of deposit (greater than 1 year)
CDs offer higher rates, but come with an early withdrawal penalty. By finding a bank CD with a reasonable early withdrawal penalty, you can enjoy higher rates but maintain access in a true emergency. Alternatively, consider building a CD ladder of different maturity lengths (ex. 1/2/3/4/5-years) such that you have access to part of the ladder each year, but your blended interest rate is higher than a savings account. When one CD matures, use that money to buy another 5-year CD to keep the ladder going. Some CDs also offer “add-ons” where you can deposit more funds if rates drop.

  • NASA FCU has special 49-month CD at 4.85% APY and 15-month CD at 5.45% APY and 9-month at 5.65% APY. $10,000 minimum of new money. The early withdrawal penalty for the 5-year is 365 days of interest. Anyone can join this credit union via partner organization.
  • Lafayette Federal Credit Union has a 5-year certificate at 4.68% APY ($500 min), 4-year at 4.73% APY, 3-year at 4.84% APY, 2-year at 4.89% APY, and 1-year at 4.99% APY. They also have jumbo certificates with $100,000 minimums at even higher rates. The early withdrawal penalty for the 5-year is very high at 600 days of interest. Anyone can join this credit union via partner organization ($10 one-time fee).
  • You can buy certificates of deposit via the bond desks of Vanguard and Fidelity. You may need an account to see the rates. These “brokered CDs” offer FDIC insurance and easy laddering, but they don’t come with predictable early withdrawal penalties. Right now, I see a 5-year non-callable CD at 4.50% APY (callable: no, call protection: yes). Be warned that both Vanguard and Fidelity will list higher rates from callable CDs, which importantly means they can call back your CD if rates drop later.

Longer-term Instruments
I’d use these with caution due to increased interest rate risk, but I still track them to see the rest of the current yield curve.

  • Willing to lock up your money for 10 years? You can buy long-term certificates of deposit via the bond desks of Vanguard and Fidelity. These “brokered CDs” offer FDIC insurance, but they don’t come with predictable early withdrawal penalties. You might find something that pays more than your other brokerage cash and Treasury options. Right now, I see a 10-year CDs at (none available, non-callable) vs. 4.06% for a 10-year Treasury. Watch out for higher rates from callable CDs where they can call your CD back if interest rates drop.
  • How about two decades? Series EE Savings Bonds are not indexed to inflation, but they have a unique guarantee that the value will double in value in 20 years, which equals a guaranteed return of 3.5% a year. However, if you don’t hold for that long, you’ll be stuck with the normal rate, currently 2.50% for EE bonds issued from May 2023 to October 2023. As of 7/7/23, the 20-year Treasury Bond rate was 4.27%.

All rates were checked as of 7/8/2023.

Filed Under: Banking, Deals & Offers, Investing //

MMB Portfolio 2023 2nd Quarter Update: Dividend & Interest Income

Posted on July 6, 2023 // 3 Comments

Here’s my 2023 Q2 income update for my MMB Portfolio. I prefer to track the income produced as an alternative metric for performance. The total income goes up much more gradually and consistently than the number shown on brokerage statements (price), which helps encourage consistent investing. I imagine my portfolio as a factory that churns out dollar bills, a tree that gives dividend fruit.

Recently, I came across this ETF Trends interview with Ryan Krueger of Freedom Day Solutions. While I don’t own the MBOX ETF, I do feel aligned with their overall philosophy of watching dividend growth. (I prefer to let the market figure things out via broad passive index fund, rather than active management.)

Crigger: What is the concept of a “Freedom Day”? And how is it different than a retirement age?

Krueger: In one sentence: Freedom Day isn’t about what asset level to retire at, but about what income number. Frankly, I don’t think retirement should be an age thing, anyway. Why not retire at 50—or if you really love what you’re doing, why not 80 or 90?

Freedom Day is our mathematical version of something better than retirement. It’s the day when your cash flow exceeds your outflows; when you finally know for certain enough is enough.

But it all comes back to income. Advisors’ biggest challenge right now is figuring out how to generate increasing income flows for their clients. As a result, investors are reaching for yield, and taking risks they might not realize are there, all to try to catch up and get that 4-5% withdrawal rate. But if you dig your income well before you’re thirsty, rising dividends oer the potential to be larger than withdrawal rates – and that’s free cash flow, not withdrawing.

Background about why I track dividends. Stock dividends are a portion of profits that businesses have decided to distribute directly to shareholders, as opposed to reinvesting into their business, paying back debt, or buying back shares. The dividends may suffer some short-term drops, but over the long run they have grown faster than inflation.

In the US, the dividend culture is somewhat conservative in that shareholders expect dividends to be stable and only go up. Thus the starting yield is lower, but grows more steadily with smaller cuts during hard times. Here is the historical growth of the trailing 12-month (ttm) dividend paid by the Vanguard Total US Stock ETF (VTI), courtesy of StockAnalysis.com.

European corporate culture tends to encourage paying out a higher (sometimes fixed) percentage of earnings as dividends, but that also means the dividends move up and down with earnings. Thus the starting yield is higher but may not grow as reliably. Here is the historical growth of the trailing 12-month (ttm) dividend paid by the Vanguard Total International Stock ETF (VXUS).

The dividend yield (dividends divided by price) also serve as a rough valuation metric. When stock prices drop, this percentage metric usually goes up – which makes me feel better in a bear market. When stock prices go up, this percentage metric usually goes down, which keeps me from getting too euphoric during a bull market. Here’s a related quote from Jack Bogle (source):

The true investor will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies. – Jack Bogle

My personal portfolio income history. I started tracking the income from my portfolio in 2014. Here’s what the annual distributions from my portfolio look like over time:

  • $1,000,000 invested in my portfolio as of January 2014 would started out paying ~$24,000 in annual income over the previous 12 months. (2.4% starting yield)
  • If I reinvested the dividends/interest every quarter but added no other contributions, as of July 2023 it would have generated ~$51,000 in annual income over the previous 12 months.
  • Even if I SPENT all the dividends/interest every quarter and added no other contributions, as of July 2023 it would have generated ~$39,000 in annual income over the previous 12 months.

This chart shows how the annual income generated by my portfolio has increased over time and with dividend reinvestment. Note that these are nominal values and interest rates and inflation have risen more recently.

I’m using simple numbers to illustrate things, but isn’t that a more pleasant way to track your progress?

TTM income yield. To estimate the income from my portfolio, I use the weighted “TTM” or “12-Month Yield” from Morningstar (checked 4/2/23), which is the sum of the trailing 12 months of interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed (usually zero for index funds) over the same period. The trailing income yield for this quarter was 3.33%, as calculated below. Then I multiply by the current balance from my brokerage statements to get the total income.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield Yield Contribution
US Total Stock (VTI) 30% 1.51% 0.45%
US Small Value (VBR) 5% 2.22% 0.11%
Int’l Total Stock (VXUS) 20% 2.94% 0.59%
Int’l Small Value (AVDV/EYLD) 5% 5.68% 0.28%
US Real Estate (VNQ) 10% 4.52% 0.45%
Inter-Term US Treasury Bonds (VGIT) 15% 2.22% 0.33%
Inflation-Linked Treasury Bonds (TIP) 15% 4.32% 0.65%
Totals 100% 2.87%

 

My ttm portfolio yield is now roughly 2.87%, a bit lower than last quarter’s value. That means if my portfolio had a value of $1,000,000 today, I would have received $28,700 in dividends and interest over the last 12 months. (This is not the same as the dividend yield commonly reported in stock quotes, which just multiplies the last quarterly dividend by four.)

What about the 4% rule? For goal planning purposes, I support the simple 4% or 3% rule of thumb, which equates to a target of accumulating roughly 25 to 33 times your annual expenses. I would lean towards a 3% withdrawal rate if you want to retire young (closer to age 50) and a 4% withdrawal rate if retiring at a more traditional age (closer to 65). It’s just a quick and dirty target, not a number sent down from the heavens. During the accumulation stage, your time is better spent focusing on earning potential via better career moves, improving in your skillset, and/or looking for entrepreneurial opportunities where you can have an ownership interest.

As a semi-retired investor that has been partially supported by portfolio income for a while, I find that tracking income makes more tangible sense in my mind and is more useful for those who aren’t looking for a traditional retirement. Our dividends and interest income are not automatically reinvested. They are another “paycheck”. Then, as with a traditional paycheck, we can choose to either spend it or invest it again to compound things more quickly. Even if we spend the dividends, this portfolio paycheck will still grow over time. You could use this money to cut back working hours, pursue a different career path, start a new business, take a sabbatical, perform charity or volunteer work, and so on.

Right now, I am trying to fully appreciate the “my kids still think I’m cool and want to spend time with me” period of my life. It won’t last much longer. I am consciously choosing to work when they are at school but also consciously turning down work that doesn’t fit my priorities and goals. This portfolio income helps me do that.

Filed Under: Goals, Investing, Retirement //

MMB Portfolio 2023 2nd Quarter Update: Asset Allocation & Performance

Posted on July 4, 2023 // Leave a Comment

Here’s my quarterly update on my current investment holdings at the end of 2023 Q2, including our 401k/403b/IRAs and taxable brokerage accounts but excluding our primary residence and side portfolio of self-directed investments. Following the concept of skin in the game, the following is not a recommendation, but a sharing of our real-world, imperfect, low-cost, diversified DIY portfolio.

“Never ask anyone for their opinion, forecast, or recommendation. Just ask them what they have in their portfolio.” – Nassim Taleb

How I Track My Portfolio
Here’s how I track my portfolio across multiple brokers and account types. There are limited free options after Morningstar discontinued free access to their portfolio tracker. I use both Empower Personal Dashboard (previously known as Personal Capital) and a custom Google Spreadsheet to track my investment holdings:

  • The Empower Personal Dashboard real-time portfolio tracking tools (free) automatically logs into my different accounts, adds up my various balances, tracks my performance, and calculates my overall asset allocation daily.
  • Once a quarter, I also update my manual Google Spreadsheet (free to copy, instructions) because it helps me calculate how much I need in each asset class to rebalance back towards my target asset allocation. I also create a new tab each quarter, so I have an archive of my holdings dating back many years.

2023 Q2 Asset Allocation and YTD Performance
Here are updated performance and asset allocation charts, per the “Holdings” and “Allocation” tabs of my Empower Personal Dashboard.

Humble Portfolio Background. I call this my “Humble Portfolio” because it accepts the repeated findings that individuals cannot reliably time the market, and that persistence in above-average stock-picking and/or sector-picking is exceedingly rare. Charlie Munger believes that only 5% of professional money managers have the skill required to consistently beat the index averages after costs.

If beating a “simple, unsophisticated” Target Retirement Index Fund was so easy, they should simply charge money for it. You give me 2% outperformance, and I’ll pay you 1%. You simply have to cover any and all losses if you happen to underperform the “simple, unsophisticated” index fund. Isn’t it strange how nobody would take that deal?

Instead, by paying minimal costs including management fees, transaction spreads, and tax drag, you can essentially guarantee yourself above-average net performance over time.

I own broad, low-cost exposure to productive assets that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out. I have faith in the long-term benefit of owning businesses worldwide, as well as the stability of high-quality US Treasury debt. My stock holdings roughly follow the total world market cap breakdown at roughly 60% US and 40% ex-US. I add just a little “spice” to the broad funds with the inclusion of “small value” ETFs for US, Developed International, and Emerging Markets stocks as well as additional real estate exposure through US REITs.

I strongly believe in the importance of knowing WHY you own something. Every asset class will eventually have a low period, and you must have strong faith during these periods to truly make your money. You have to keep owning and buying more stocks through the stock market crashes. You have to maintain and even buy more rental properties during a housing crunch, etc. A good sign is that if prices drop, you’ll want to buy more of that asset instead of less. I don’t have strong faith in the long-term results of commodities, gold, or bitcoin – so I don’t own them.

I do not spend a lot of time backtesting various model portfolios, as I don’t think picking through the details of the recent past will necessarily create superior future returns. You’ll find that whatever model portfolio is popular in the moment just happens to hold the asset class that has been the hottest recently as well.

Find productive assets that you believe in and understand, and just keep buying them through the ups and downs. Mine may be different than yours.

I have settled into a long-term target ratio of roughly 70% stocks and 30% bonds (or 2:1 ratio) within our investment strategy of buy, hold, and occasionally rebalance. My goal is more “perpetual income portfolio” as opposed to the more common “build up a big stash and hope it lasts until I die” portfolio. My target withdrawal rate is 3% or less. Here is a round-number breakdown of my target asset allocation.

  • 30% US Total Market
  • 5% US Small-Cap Value
  • 20% International Total Market
  • 5% International Small-Cap Value
  • 10% US Real Estate (REIT)
  • 15% US Treasury Nominal Bonds or FDIC-insured deposits
  • 15% US Treasury Inflation-Protected Bonds (or I Savings Bonds)

Details. According to Empower, my portfolio went up about 8.8% YTD to 7/4/2023. The S&P 500 is up 16% YTD, while the US Bond index is up about 2%. Remaining invested with stocks has paid off this year significantly more than worrying about the details of Treasury bills and cash rate-chasing.

There was only minor rebalancing with cashflows (mostly dividends) this quarter. I loosely keep up with the new DFA and Avantis ETFs that come out, but am somewhat limited in what I buy as I have lot of capital gains built up right now. DFA has an International Small Cap Value ETF (DISV) and an Emerging Markets Value ETF (DFEV). Avantis also has an Avantis International Small Cap Value ETF (AVDV) and Avantis Emerging Markets Value ETF (AVES). I’ll keep them in mind if there are future drops and other tax loss harvesting opportunities.

I’ll share about more about the income aspect in a separate post.

Filed Under: Goals, Investing, Retirement //

Simple Personal Finance Lessons and Quotes from Harry Markowitz (1927-2023)

Posted on June 27, 2023 // Leave a Comment

Harry Markowitz, who received the 1990 Nobel Prize in Economics for his contributions in creating modern portfolio theory, passed away recently. He introduced the use of mathematical methods to illustrate the power of diversification and how you can combine multiple different components into a portfolio that can achieve the highest expected return while taking on the minimum amount of risk. This NY Times obituary outlines his long list of achievements.

These days, anyone can run many backtests to optimize for a historically optimal portfolio using a number of different asset classes (as of today, it will be different in 5 or 10 years). However, if you listen to many of his interviews, Markowitz doesn’t necessarily think the average investor needs optimize relentlessly. Here are some useful quotes that don’t require any advanced math.

From his landmark 1959 book Portfolio Selection: Efficient Diversification of Investments:

A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.

How did Harry Markowitz actually run his own personal portfolio? From Jonathan Zweig’s NYT article about emotions and investing:

Mr. Markowitz was then working at the RAND Corporation and trying to figure out how to allocate his retirement account. He knew what he should do: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.” (That’s efficient-market talk for draining as much risk as possible out of his portfolio.)

But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.” As Mr. Zweig notes dryly, Mr. Markowitz had proved “incapable of applying” his breakthrough theory to his own money. Economists in his day believed powerfully in the concept of “economic man”— the theory that people always acted in their own best self-interest. Yet Mr. Markowitz, famous economist though he was, was clearly not an example of economic man.

From a Chicago Tribune interview by Gail MarksJarvis:

Early in his career, he did not take the risks some investment advisers suggest for young investors to maximize returns. Rather, he saved regularly and put half his money into stocks and half into bonds to grow while controlling risks. When he thought he had accumulated too much in either category, he stopped putting money there for a while and directed savings to the neglected group. […]

“I never sold anything,” he said. If stocks were increasing in value, he would let that portion grow for a while, but eventually he would stop stock purchases and beef up the bonds. The idea: The bonds would insulate him from the downturns that crush stocks from time to time without clear warning. […]

“Say you were 65, and invested $1 million, with 60 percent in stocks and 40 percent in bonds,” he said. “It became $800,000 [during the financial crisis], and you are not happy, but you lived to invest another day.”

From this Business Insider article via Bogleheads forum post (emphasis mine):

In an interview with Personal Capital, Markowitz was asked, “What are the top pieces of advice you give people about money?”

“I only have one piece of advice: Diversify,” he replied. “And if I had to offer a second piece of advice, it would be: Remember that the future will not necessarily be like the past. Therefore we should diversify.“

From ThinkAdvisor:

“Perhaps the most important job of a financial advisor is to get their clients in the right place on the efficient frontier in their portfolios,” he told me. “But their No. 2 job, a very close second, is to create portfolios that their clients are comfortable with. Advisors can create the best portfolios in the world, but they won’t really matter if the clients don’t stay in them. “

Thank you, Mr. Markowitz, for your contributions to economics, behavioral finance, and investing. Thanks also for the simple, actionable lessons that don’t require a degree in mathematics or economics: keep saving regularly, maintain a diversified portfolio of both stocks and bonds, rebalance when it gets off, and stick with it for a long time (don’t panic sell).

Image credit: Quantpedia

Filed Under: Investing //

Fidelity Investments: $100 New Account Offer Includes IRAs, New and Existing Customers

Posted on June 26, 2023 // 26 Comments

Updated. Fidelity Investments is offering a $100 bonus for opening a Fidelity taxable brokerage account (“The Fidelity Account”), Cash Management Account (“CMA”), Roth IRA, or traditional IRA. You can also do the “Starter Pack” (Fidelity Account + CMA), but you can also open just a single account of any type. Hat tip to reader Chuck.

Open with the promo code FIDELITY100 and deposit $50 or more within 15 calendar days after opening your account. Fidelity will give you a $100 bonus within 25 days after opening your account. You must then maintain the bonus award (minus any losses related to trading or market volatility, or margin debit balances) in the account for at least 90 days from the date on which the bonus award is credited to the account.

Per the fine print, this is available to both new and existing customers who haven’t taken advantage of this offer before. Basically, you can already have other Fidelity accounts; they just want you to open an additional new account. You just can’t have done this bonus before.

This offer is valid for new or existing Fidelity Brokerage Services LLC or Fidelity Personal and Workplace Advisors LLC (“Fidelity”) customers who open through the following link https://www.fidelity.com/go/starter-pack and fund a new, eligible Fidelity account with a minimum of $50 on or after 3/9/2023 and have not otherwise previously taken advantage of Fidelity’s $50 for $100 cash offer, or Fidelity’s $50 for $150 cash offer. Offer is limited to one bonus award per individual.

You should receive a confirmation email:

As a confirmation of your registration, an email will be sent to the email address you provided during the account opening process after the eligible account has been established in good order.

Right now, I don’t know of any alternative Fidelity bonuses for transferring over new account assets from another broker.

This is a relatively simple and straightforward bonus, and the Fidelity Account offers solid customer service and a good feature set (decent cash sweep, no stock/ETF commissions, ability to buy Treasury bonds and brokered CDs). I would personally much rather trade stocks at Fidelity than deal with Robinhood customer service, for example. There are also bonuses available for their fintech Bloom and Youth brokerage accounts (13-17yo).

Filed Under: Deals & Offers, Investing //

Treasury Bonds vs. TIPS vs. Lifetime Income Annuities Compared

Posted on June 25, 2023 // Leave a Comment

These days, when I see an article titled The Best Current Sources of Retirement Income, I expect to be pitched some sort of options-based ETF with 12% yield or high-yield junk bonds with a 9% yield. However, this Morningstar article actually provided a reasonable comparison of three high-quality options for “guaranteed” income:

  • Traditional US Treasury Bonds, which offer a fixed interest payment for the remaining term of the bond (plus return of principal).
  • Treasury Inflation Protected Securities (TIPS), which offer a variable interest payment that is a fixed amount above an inflation-linked index (plus return of principal).
  • Single Premium Income Annuities, where you put up all your money upfront and then receive a fixed amount for the rest of your lifetime.

There are some additional assumptions, but here is a chart assuming a $100,000 investment, starting at age 65 with a 20-year time horizon that experiences 2.4% annual inflation (2.4% is the average long-term prediction of future inflation):

The chart seems to suggest that if you buy an annuity and then die the next year, you would lose your entire $100,000. That can be the case, but every SPIA annuity quote that I’ve seen offers the option to guarantee a certain minimum number of payments like 5 or 10 years of income, or a complete return of premium ($100,000 in this case). You do pay for this additional rider in the form of a lower monthly payout, but it is a popular option.

Don’t forget about Social Security. The article reminds us that an alternative option for government-guaranteed, inflation-adjusted income is to delay your Social Security start date and increase your future monthly payments for the rest of your life. Your cost is using your own funds to replace your income during those additional delayed years before claiming.

The results are about as you might expect, but it’s nice to see it illustrated using charts. My lightning recap:

  • Moderate inflation (2.4%) + Average Lifespan: Mostly a tie.
  • High inflation (5%) + Average Lifespan: TIPS win.
  • Low inflation (1%) + Average Lifespan: Treasury bonds win.
  • Moderate inflation + Extended Lifespan: SPIA lifetime annuity wins.

Since we don’t know the future, there is no “best” option. However, this comparison helps you understand why you’d own each option. If everything goes as forecasted, it won’t really matter what you pick. But I bother with owning all three types because I like knowing that I am covered in all of the more extreme scenarios. I don’t plan on buying a lot of private annuities, however, as Social Security is already an annuity that offers lifetime inflation-adjusted income. If needed, I plan to simply delay my Social Security claim date if I wish to increase my annuity allocation.

Filed Under: Investing //

Why I Don’t Use Covered Calls As a Retirement Income Strategy

Posted on June 8, 2023 // 19 Comments

Eventually, you will be presented with the idea of writing covered calls on your portfolio and earning “easy income” from this strategy. I already know intuitively that there must be a cost to this “passive income” and that the net effect is worse performance than simply holding the same index fund or stock for the long term. However, the pushback is usually that you can get a more reliable cashflow in exchange for giving up some of your upside.

The article The Hidden Cost of Covered Call Writing (via Abnormal Returns) does a good job of explaining why there is unfortunately no “free lunch” with this strategy, even if your goal is to create steady income.

Many investors focus on the call premium as a source of portfolio “income” while still participating in a limited amount of appreciation of the stock. As long as the stock stays below the strike price and the call expires worthless, the strategy can generate positive portfolio income, making it ideal for flat or down markets. However, trying to time when stocks and markets will be flat or down is extremely difficult, particularly given the long-term upward bias of the equity markets. As such, there is a hidden cost of covered call writing, which is the potentially significant opportunity cost of having the stock go above the strike price causing lost portfolio appreciation.

Covered calls work great when they work out, since you get to keep your stock and the “free income”. Giving up your upside may seem like a good deal, but you must realize that much of the stock market’s return comes from lumpy periods where it shoots up without warning.

The chart below from the article compares the performance results between simply withdrawing 3% a year from your S&P 500 portfolio from 2013 to 2022, as opposed to writing covered calls with a 3% yield on your S&P 500 portfolio. The chart does add a 0.75% annual management fee for this approach, but even if you add that back in, the difference is still 11.3% vs. 9.2% annualized return.

Lower volatility is also commonly cited as a benefit of a covered call strategy. Well, yeah, if you limit your upside every time the strike price is exceeded, then you will have lower volatility.

In a rising market, covered calls may actually reduce upside portfolio volatility, which is the type of volatility that investors benefit from. As such, when evaluating covered call strategies that show lower volatility statistics than the broader market, investors should be mindful of where that volatility reduction may be coming from.

Am I willing to give up 2% in annual returns for a steady income? Nope. I mean, 2% is already roughly the entire dividend yield of the S&P 500. The problem is that most people who use this strategy aren’t properly tracking their performance and probably won’t know if they are lagging behind simple buy and hold. The call premium income comes in most of the time, so it’s easy not to realize the true cost of missing out on the gains.

There are certainly scenarios where if you think you have an information edge, knowing how to structure an option can help you make the right bet. But they aren’t magic! I am very skeptical of the idea of any options strategy that will somehow give you reliable income without a significant cost of hurting your total returns. That just gives me the same feeling of someone who claims to invent a machine that defies a basic law of physics.

Filed Under: Investing, Retirement //
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